What is fundamental analysis?

There are two basic approaches to market analysis -- technical analysis (of market data) and fundamental analysis (of market environment). For academics, fundamental analysis is the study of supply and demand forces in the economy. For traders, it is a method to forecast price movements of individual commodities and/or entire markets by looking at economic indicators and government policy, within a business cycle framework. Because there are hundreds of supply and demand forces in effect at any particular time, the fundamental analyst builds economic models to reduce the number of these variables to a few dominant forces. The efficacy of these models is limited only by the analyst's ability to identify dominant factors.

Does fundamental analysis explain or forecast market behavior?

It can do both, depending on the economic variables used. In an explanatory model, the variables used are measured at the same time as the price they seek to explain. In a forecasting model, either past values are used to extrapolate future values (the explanatory variable must really be predictive), or, a knowledge of forces outside a particlar commodity is used to forecast future prices (the explanatory variable must have high correlation). To use fundametal forecasting for trading, one does not trade until the sufficient precursor conditions materialize.

Forecasts are as strong as the data used to make them. Much fundamental data, no matter how accurate the estimates, is based on samples. In addition, the estimates are usually subject to constant revision. Thus, a forecast based on price data, such as in technical analysis, promises to have greater accuracy.

Through model building, one may have a thorough understanding of a market's structure, but still have no information that will lead to the profitable establishment of market positions. A myth surrounding fundamental analysis in futures is that explaining price changes is equivalent to forecasting price changes.

While the building blocks of all fundamental analysis includes indicators for supply, demand and government economic policy, forecasting models usually include at least one type of economic indicator in relation price data.